Cut can hurt

If RBI has kept the interest rates unchanged, it is to cushion the volatile rupee

In his monetary policy statement this week, RBI Governor D. Subbarao took a difficult and unpopular decision. He kept the policy interest rate unchanged despite the clamour for cutting it. The decision not to cut rates was obvious if one looks at the inflation data. A 10 per cent consumer price inflation could have justified a rate hike, but given the slowdown and the pressure on the RBI, perhaps it was what a rate cut would do to the rupee that played a key role in the decision.

Most advanced countries, and a few emerging economies, have made legal and institutional arrangements to reduce the political pressure on central banks to cut rates. They have explicitly given the central bank a mandate to maintain price stability or target inflation. Industry, bankers and financial sector participants are the most vocal sections of society, and they always want lower interest rates. But most countries saw that not focusing on price stability but on growth only results in high and volatile inflation as households expect higher inflation, and higher wages creep into labour contracts, creating higher inflation.

The political solution towards the goal of achieving a low and stable inflation rate was to make the central banks independent and accountable for price stability. This way, in the political fight, the central banker could always be held up as the bad guy who raised interest rates. Normally this happens when an economy is overheating, and over time most bankers and firms call the central bank the party pooper, but accept the rate hikes. However, it is most difficult in the case of a stagflationary environment. In such an environment one would expect an inflation-targeting central bank to raise interest rates. But when a central bank, which does not have an explicit inflation mandate, resists political pressure and keeps interest rates unchanged, as the RBI did this week, many observers could be surprised, as has happened this time.

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